Doing Due Diligence What it means and why it's so important to investors
By David Newton •
Opinions expressed by Entrepreneur contributors are their own.
Several readers have expressed concern about not knowing what is meant by "due diligence" as it relates to potential funding sources for their emerging ventures. Here's how to think of it: It's actually a very simple concept with many interpretations and multiple levels of implementation.
First, the definition should mean nothing more than an investor being "diligent" when checking out the substance of the claims made by an entrepreneur with respect to the market, the product or service concept, the competition, the management team and so on. The term "due" means that it's expected and someone has to perform this task. So the concept is really all about the diligence that is due the investigation into an emerging company's plan for doing business. There are some in the financing environment who expect this to be done by the entrepreneur on behalf of the investors, and that's a completely wrong understanding. The company founder makes some form of disclosure within the business plan, but the responsibility to follow-up on and check out the statements made in that document falls squarely on the shoulders of the investor. For the scope of your financing experiences, always assume that the potential funding source is the one that will check and recheck everything presented by the entrepreneur.
The next issue to consider is how the due diligence gets accomplished. As I said before, this varies considerably from deal to deal. At the first level, a potential investor may pass the business plan along to a colleague who has specific experience in the same (or a similar) area of the new venture. Technical drawings, terminology, articles cited, machinery or processes described, pricing and shipping practices, and marketing channels are all examples of categories within the plan that need to be checked carefully by investors to see if the entrepreneur really knows what he or she is talking about. Certain industries may have very unique issues in these and other company functions. A skilled eye with experience in that same market space will be able to comment on the accuracy of the statements made. If your general contracting business idea doesn't convey a clear understanding of the specific issues related to building supplies, pricing, payment terms or financial commitments on real estate, then due diligence should readily pick up on these as red flags that bring into question the overall quality of the deal.
Due diligence can also go several steps further. Investors will often pick up the phone and contact people or companies named in your business plan. If Jill Smith is listed on your advisory board with an impressive electrical engineering background, investors will want to speak directly with her and follow-up on where she went to school, how long has she been in the industry and hear her version of what she's doing on the board. If Jones and Jones Inc. is listed in the plan as the primary supplier of parts inventory to the new venture, not only will investors want to talk with shipping and manufacturing people at Jones and Jones, but they may also want to visit the factory to meet the owners and production crew and see the operation firsthand. When an accounting practice, law firm or design company is named in the plan, a thorough due diligence speaks directly with each of these and discusses the extent of the business relationship with the entrepreneur and the new company.
This also applies to statements about patents, trademarks, exclusive contracts and deals currently in process with a large buyer. Investors would like to mitigate as many risks as possible related to the funding opportunity. Due diligence simply allows them to check and double-check the pertinent pieces of the deal before deciding whether to provide capital. So don't get upset when an exhaustive due diligence is performed on your business proposal. If everything's accurate in your presentation, then the due diligence will further validate that fact and investors will be more likely to put money into your deal.
David Newton is a professor of entrepreneurial finance and head of the entrepreneurship program, which he founded in 1990, at Westmont College in Santa Barbara, California. The author of four books on both entrepreneurship and finance investments, David was formerly a contributing editor on growth capital for Industry Week Growing Companies magazine and has contributed to such publications as Entrepreneur, Your Money, Success, Red Herring, Business Week, Inc. and Solutions. He's also consulted to nearly 100 emerging, fast-growth entrepreneurial ventures since 1984.
The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.
